Sunday, September 16, 2007

It’s Just a Matter of Equity

Published: September 16, 2007

The moribund private equity market stirred a bit last week as Kohlberg Kravis Roberts dredged up some buyers for loans to finance its $22 billion purchase of Alliance Boots, a British drugstore chain. But lingering investor wariness toward private equity maestros and their deals is far from the only problem facing the buyout business. There are graver threats that are, no surprise, the industry’s own making.

This is not just your humble research assistant talking. It is the view of Michael C. Jensen, professor emeritus at the Harvard Business School, leading scholar in finance and management, and the man whom many consider to be the intellectual father of private equity. In other words, a person uniquely qualified to opine on the matter.

“We are going to see bad deals that have been done that are not publicly known as bad deals yet, we will have scandals, reputations will decline and people are going to be left with a bad taste in their mouths,” Mr. Jensen said in an interview last week. “The whole sector will decline.”

Mr. Jensen was elaborating on the trenchant comments he made last month in a forum on private equity convened by the Academy of Management. There, he excoriated private equity titans who sell stock in their companies to the public — a non sequitur in both language and economics, he said — and warned that industry “innovations,” like deal fees that encourage private equity managers to overpay for companies, will destroy value at these firms, not create it.

He also said that private equity managers who sell overvalued company shares to the public, whether in their own entities or in businesses they have bought and are repeddling, are breaching their duties to those buying the stocks.

“The owners who are selling the equity are in effect giving their word to the market that the equity is really worth what it is being priced at,” he said. “But the attitude on Wall Street is that there is no responsibility to the buyers of the equity on the part of the managers who are doing the selling. And that’s a recipe for nonworkability and value destruction.”

Mr. Jensen’s interest in private equity goes back to 1989, when he wrote a seminal article titled “Eclipse of the Public Corporation.” In it he argued that new and more effective organizations were emerging that unified the interests of managers and owners, eliminating value-destroying practices so common at public companies.

These practices, examples of the so-called agency problem, are a product of corporate structures that allow managers — i.e., agents — to feather their own nests at the expense of owners — i.e., investors — whose interests they are supposed to serve.

For years, private equity firms seemed superior to the public company model, Mr. Jensen said. But recent developments, he said, have wiped out many of the advantages in private equity’s original design. Agency problems, precisely what private equity was supposed to eliminate, are cropping up as a result of the disastrous changes made by these firms, Mr. Jensen argues.

Raising permanent capital by issuing stock in a private equity firm is a prime example, because it destroys powerful incentives that kept these firms working hard for their investors, Mr. Jensen said. In traditional form, private equity firms raise capital from investors for a finite period of time, agreeing to pay them back, typically after 3 to 13 years. This not only provides a reasonable time horizon for gauging how well the firms perform, it also contains an implicit threat that if they don’t produce for their partners then they won’t be able to raise additional funds.

“This gives the capital markets a chance to say no,” Mr. Jensen said. “When you liquidate a fund if you don’t have very good returns, you’re going to have a tough time on the next fund. That’s a very, very important constraint that has played a significant role in the success of the private equity model.”

Mr. Jensen also deplores the newfangled fees that private equity firms are levying on their clients. Among the worst? Deal fees that rise in tandem with the size of the buyout, and special dividends that go only to the private equity firm, not its investors.

“Deal fees that are going to pay them to do deals whether they are good or not — now that’s nuts,” Mr. Jensen said. “And this notion of taking special dividends out only for the private equity firm — you can see the conflicts of interest that creates.”

Under the original model, private equity managers got annual management fees, but their biggest payout was supposed to be on the back end, based on the performance of the companies they had operated. But waiting for a back-end payday is not enough for today’s titans. They want their money up front.

“I can predict without a shred of doubt that these fees are going to end up reducing the productivity of the model,” Mr. Jensen said. “And it creates another wedge between the outsiders and insiders, which is very, very serious. People are doing this out of some short-run focus on increasing revenues, and not paying attention to what the strengths of the model are.”

Who cares about the model when there’s a mountain of money to be made?

Short-term thinking like that can do genuine damage, and Mr. Jensen fears such a result. “The sector is going to take a reputational hit of nontrivial proportions,” he said. “Private equity is not going to go away, but it’s going to take a hit.”

A sunny side to this dark view is that public company managers may begin applying parts of the private equity model to their own operations, according to Mr. Jensen.

“In principle, one ought to be able to duplicate virtually every aspect of the private equity model in a public company, except the actual going-private part,” he said. “It’s very difficult, but I think public corporations may begin to think about running themselves in this way.”

Now that’s something to hope for.


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